Why the neutral rate is climbing

plus, BRICs and payments, big bank blockchains

“The purpose of life is to be defeated by greater and greater things.” – Rainer Maria Rilke ||

Hello everyone, I hope you’re all doing well!

I’m not writing a market comment today since 1) I’m sending this email much earlier than usual as I’m in London and have to rush out the door, and 2) I have no idea why the BTC did what it did yesterday.

Below, I talk about interest rates, why I think now both the market and the Fed are overestimating the cuts ahead, and what that could mean for crypto markets. I also look at what BRICS is up to, and another big bank platform. It’s a long one today, but since you won’t hear from me until Monday, I figured it averages out!

Programming note: I’m on the road this week, so this newsletter will be taking a break until Monday. I’m looking forward to the recharging time, not gonna lie. 😊

IN THIS NEWSLETTER:

• Why the neutral rate is climbing

• Big bank blockchain networks

• Can BRICS pull it off?

If you’re not a premium subscriber, I hope you’ll consider becoming one!

WHAT I’M WATCHING:

Why the neutral rate is climbing

Current debates about how much and how fast the US Federal Reserve will cut rates overlook a key factor: we don’t know how restrictive the fed funds rate actually is.

Looking at financial conditions indices, you could argue that they’re not restrictive at all. According to the Chicago Fed, conditions are even looser now than just before the Fed started hiking rates in early 2022.

(chart via the Chicago Fed)

Fed Chair Powell, however, insists in his speeches and post-FOMC press conferences that policy is restrictive. He admits, though, that they don’t know how much. It all depends on what the “neutral” rate is. Interest rates higher than neutral can be considered restrictive, and rates lower than neutral can be considered stimulative.

So, what is the neutral rate? No-one knows.

The “neutral” interest rate, also known as r-star or r*, is the rate at which inflation and employment are at acceptable levels and stable.

The thing is, that changes over time and depends on many inputs, including commodity prices, trade conditions, demographics, etc. There are models that can spit out estimates of what it might be today and going forward, but these estimates are flimsy at best. Even Powell acknowledges that there is no way of knowing what neutral is or will be – his phrase, tellingly repeated a few times in the most recent FOMC press conference, is “we’ll know it by its works”. In other words, when the Fed’s economists feel that inflation and employment are settled, that’s the neutral rate.

Yet even that is uncertain, since economies are always in flux. Will we know it when we see it? Still, it’s an elusive target but at least it’s something to aim at.

We can get an idea of what the Fed thinks r-star is from its long-run fed funds target. According to the latest economic projections from the central bank, this is 2.9% (or 0.9% on a real basis, adjusting for the long-run 2.0% inflation target). So, yes, relative to that, rates are restrictive.

But here’s something interesting: at the beginning of this year, it was 2.5%, roughly the same as pre-pandemic r-star expectations. The neutral rate estimate is moving up.

Why?

As far as I know, the Fed hasn’t given a concrete answer for that, but nor can it credibly do so, since the number is a consensus estimate with each central bank economist pencilling in a different guess. The range is wide, between 2.4% and 3.8%, and evenly dispersed.

(Sept 2024 dot plot, via the Federal Reserve)

But while the range is still the same as in early 2024, uncertainty is increasing. Check out the move in the dispersion between last month’s dot plot and that of December 2023.

(Dec 2023 + Sept 2024 dot plots, from the Federal Reserve)

Not only is uncertainty increasing, but suspicions seem to be consolidating that r-star is higher than the pre-pandemic norm.

Why is r-star climbing?